Magazine

Commentary: Reform the Exchange -- Gingerly

October 05, 2003

Over the last decade, the U.S. financial markets -- and the New York Stock Exchange in particular -- have been one of the few U.S. sectors to gain market share globally. While formerly dominant industries such as commercial airline manufacturing have lost ground, the NYSE still reigns supreme, with far more liquidity than any other trading system or exchange. In the first half of the 1990s, the NYSE accounted for 28% of the value of all shares traded globally. By 2002, that had risen to almost 31%. Even after two years of Wall Street scandals, the strength of the U.S. financial markets -- their attractiveness to traders, their ability to withstand shocks, their success in financing both existing corporations and new businesses -- is a key competitive advantage of the U.S. economy.

That's why, in the aftermath of Richard Grasso's resignation as Big Board chairman, it's essential that NYSE reformers tread carefully. There is plenty of pressure to make major changes in the exchange. Nevertheless, the history of regulation shows that bad consequences often can arise from good intentions. In particular, anything that hurts the ability of the NYSE and the financial markets to compete could hurt the U.S. economy as well.

True, the NYSE needs to make changes. The reforms, however, should focus on improving the transparency of the exchange's operations and governance rather than imposing new rules. More openness would have made it harder for Grasso to get such an outsize pay package. Better governance -- including creating a board with a majority of independent members -- would bolster the faith of both institutional and retail investors and better protect their interests.

Problem is, the reformers may not stop there. There are signs that the Securities & Exchange Commission will want the NYSE to shift its resources to better monitor the markets to prevent abuses such as insider trading and front running, in which floor brokers profit from advance knowledge of large trades. That would force the exchange to focus less on doing business development. Moreover, later in the fall the SEC may consider a major modification of what's known as the trade-through rule, which today requires orders to flow to the NYSE if its specialists are quoting the best price. Changing the trade-through rule -- a proposal that the SEC has been working on for six months -- would benefit institutional traders, who now complain that they often don't get the quoted price from the specialists. Instead of trading on the NYSE, they want to divert much of their business to electronic trading systems that offer faster trades at prices nearly as good.

Despite the genuine appeal of these reforms, either could well backfire. Increasing the intensity of regulation and reducing spending on business development could significantly reduce the NYSE'S competitiveness, especially since the focus on attracting new listings has helped the exchange maintain its global primacy. Equally important, the trade-through rule helps ensure a high volume of trades -- and liquidity -- for the NYSE. That's a real plus. Allowing institutional investors to spread their trades out among different exchanges may be preferable in most circumstances, but it might make it harder to maintain liquidity in periods of financial stress.

The NYSE, for all of its foibles and flaws, has successfully served as the bulwark of the financial system through boom and bust. That means major reforms should be made carefully. In particular, the fact that institutional investors would prefer to trade off the exchange is not conclusive evidence that it would lead to a better financial system.

The stock exchange clearly made a mistake by paying Grasso so much money. But if the response is too draconian, the rest of the economy will suffer for the sins of a few. By Michael J. Mandel